Production Management Assignment

The Economic Order Quantity Model

Name: Stita Pragyna Misra Class: PGDM III (2011-13) Roll No. : 156 Welingkar Institute of Management Development and Research

The Economic Order Quantity (EOQ) Model

Overview: Economic order quantity is the order quantity that minimizes total inventory holding costs and ordering costs. It is one of the oldest classical production scheduling models. The framework used to determine this order quantity is also known as Wilson EOQ Model or Wilson Formula. The model was developed by Ford W. Harris in 1913, but R. H. Wilson, a consultant who applied it extensively, is given credit for his in-depth analysis. The economic order-quantity model considers the tradeoff between ordering cost and storage cost in choosing the quantity to use in replenishing item inventories. A larger order-quantity reduces ordering frequency, and, hence ordering cost/month, but requires holding a larger average inventory, which increases storage (holding) cost/month. On the other hand, a smaller order-quantity reduces average inventory but requires more frequent ordering and higher ordering cost/month. The cost- minimizing order-quantity is called the Economic Order Quantity (EOQ). The EOQ model is the best known and most fundamental inventory decision model. Although this model is too over simplified to represent most real world situation, it is nevertheless, an excellent starting point from which to develop complex and more realistic inventory decision models.

Historical Background The EOQ model and formula are attributed to Ford Whitman Harris ( Harris, 1913 ), and originally published in 1913 in Factory, The Magazine of Management. However, despite this magazines wide circulation among manufacturing managers, Harris article had been lost until it was found by Erlenkotter. In the years between Harris article being lost and found, the EOQ model, and, in particular, the square-root equation, (4), was attributed to others, some calling it the Wilson lot size formula, others calling it Camps formula. Erlenkotter (1989) describes the early development of the EOQ literature and sketches the life of Harris as an engineer, inventor, author, and patent attorney.

Where: A = Demand for the year Cp = Cost to place a single order Ch = Cost to hold one unit inventory for a year

Assumptions: As is the case with all models, the validity of EOQ model depends on a number of assumption are as follows:i. ii. iii. Inventory is replenished when the inventory is exactly equal to zero (no shortage). Demand (usage) rate is known and is constant. Lead time, the interval between the order is placed and the time it is received, is known and constant. iv. v. Carrying cost is linear throughout the entire inventory and varies with average inventory. Price of the product does not depend on the quantity purchased. (The purchase price of the item is constant i.e. no discount is available) vi. vii. viii. ix. Ordering of the products is independent of ordering other products. The ordering cost is constant. The replenishment is made instantaneously, the whole batch is delivered at once. Only one product is involved.

The above graph illustrates the variation of the inventory level over time for the classic EOQ model. The down ward sloping curve indicates that the inventory level is being reduced at a constant rate over consumption time. Inventory level equal to Q when each new order is physically received into store. Furthermore, the inventory is gradually depleted until it reaches zero just at the point when the new order is received. The average inventory (Q/2) is, thus, equal to one half number of this within the same period. The economic order quantity will be optimal when all five assumptions are satisfied. In reality, few situations are so simple. Nonetheless, the EOQ is often a reasonable approximation of the appropriate lot size, even when several of the assumptions do not quite apply. Here are some guidelines on when to use or modify the EOQ. Don't use the EOQ - If you use the "make-to-order" strategy and your customer specifies the entire order be delivered in one shipment - If the order size is constrained by capacity limitations such as the size of the firm's ovens, amount of testing equipment, or number of delivery trucks Modify the EOQ If significant quantity discounts are given for ordering larger lots If replenishment of the inventory is not instantaneous, which can happen if the items

must be used or sold as soon as they are finished without waiting until the entire lot has been completed (see Supplement D, "Special Inventory Models," for several useful modifications to the EOQ)

Use the EOQ If you follow a "make-to-stock" strategy and the item has relatively stable demand. If your carrying costs and setup or ordering costs are known and relatively stable

THE MODEL FORMULATION The first step in constructing the inventory model is to define its variable and parameters. Let: Q= order quantity Q* = optimal order quantity D = annual demand quantity S = fixed cost per order (not per unit, typically cost of ordering and shipping and handling. This is not the cost of goods) H = annual holding cost per unit (also known as carrying cost or storage cost) (warehouse space, refrigeration, insurance, etc. usually not related to the unit cost) The Total Cost function

The single-item EOQ formula finds the minimum point of the following cost function: Total Cost = purchase cost + ordering cost + holding cost Purchase cost: This is the variable cost of goods: purchase unit price annual demand quantity. This is PD Ordering cost: This is the cost of placing orders: each order has a fixed cost S, and we need to order D/Q times per year. This is S D/Q Holding cost: the average quantity in stock (between fully replenished and empty) is Q/2, so this cost is H Q/2

. To determine the minimum point of the total cost curve, partially differentiate the total cost with respect to Q (assume all other variables are constant) and set to 0:

Solving for Q gives Q* (the optimal order quantity):

Therefore:

Q* is independent of P; it is a function of only S, D, H.

Extensions Several extensions can be made to the EOQ model, including backordering costs and multiple items. Additionally, the economic order interval can be determined from the EOQ and the economic production quantity model (which determines the optimal production quantity) can be determined in a similar fashion. A version of the model, the Baumol-Tobin model, has also been used to determine the money demand function, where a person's holdings of money balances can be seen in a way parallel to a firm's holdings of inventory. Variations There are many variations on the basic EOQ model. I have listed the most useful ones below. Quantity discount logic can be programmed to work in conjunction with the EOQ formula

to determine optimum order quantities. Most systems will require this additional programming. Additional logic can be programmed to determine max quantities for items subject to

spoilage or to prevent obsolescence on items reaching the end of their product life cycle. When used in manufacturing to determine lot sizes where production runs are very long

(weeks or months) and finished product is being released to stock and consumed/sold throughout the production run you may need to take into account the ratio of production to consumption to more accurately represent the average inventory level. Your safety stock calculation may take into account the order cycle time that is driven by

the EOQ. If so, you may need to tie the cost of the change in safety stock levels into the formula.

Example:

A basic problem for businesses and manufacturers is, when ordering supplies, to determine what quantity of a given item to order. A great deal of literature has dealt with this problem. Many formulas and algorithms have been created. Of these the simplest formula is the most used: The EOQ (economic order quantity) or Lot Size formula. The EOQ formula has been independently discovered many times in the last eighty years. The EOQ formula is simplistic and uses several unrealistic assumptions. This raises the question, which we will address: given that it is so unrealistic, why does the formula work so well? Indeed, despite the many more sophisticated formulas and algorithms available, even large corporations use the EOQ formula. In general, large corporations that use the EOQ formula do not want the public or competitors to know they use something so unsophisticated. It is useful at this point to consider a numerical example. Lets assume that the demand for boltss is 50 per week. The order cost is Rs.30 (regardless of the size of the order), and the holding cost is Rs.6 per bolt per week. Plugging these figures into the EOQ formula we get:

This brings up a little mentioned drawback of the EOQ formula. The EOQ formula is not an integer formula. It would be more appropriate if we ordered bolts by the gallon. Most of the time, the nearest integer will be the optimal integer amount. In this case, the total inventory cost T is Rs.134.18 per week when we order 22 bolts. If instead, we order 23 bolts the cost is Rs.134.22.

A graph of this problem is illuminating: Figure 2. Because the graph is so flat at the optimal point, there is very little penalty if we order a slightly sub-optimal quantity. We can better understand the graph if we view the combined graphs of the order costs and the holding costs given in Figure 3. The basic shapes of all three graphs (total costs, order costs, holding costs) are always the same. The graph of order costs is a hyperbola; the graph of holding costs is linear;

and as a result the graph of the total costs (T ) is convex. This can also be seen in that the

function

increasing and the function

is positive everywhere. If we plug the optimal quantity, Q*, into this last formula we get:

Ordinarily this last quantity is very small, which indicates that the total cost of inventory T changes very slowly with Q (in the optimal region). Hence the assumptions of the EOQ model do not have to be accurate because the problem usually is tolerant of errors. If you study closely the graphs in Figure 3, it may seem clear to you that their sum, T, reaches a minimum precisely where the two graphs intersect; that is at the point where order costs and holding costs are equal.

The gives us the equality. Solving that equality way to derive the EOQ formula.

is the easiest

Application: Cash Management The EOQ model can be applied to any quantity decision that is repeated over time, where there is a trade-off between a fixed cost (i.e., EOQs order cost K) and a variable cost associated with that decision (i.e., EOQs inventory-holding cost), and where the choice is based on minimizing the cost/time associated with that decision. The most popular such application involves the management of cash. The simplest version of a cash-management scenario corresponds to the basic EOQ scenario, but with its inputs

reinterpreted. In particular: D is the rate at which cash is being accumulated from some business activity into a noninterest bearing account (e.g., checking account); h is the interest being paid in an interest-bearing account (e.g., money-market account), and is measured in dollars/(dollar x time); and K is the fixed cost incurred in transferring any amount of money, Q, from the noninterest to the interest-bearing account. Hence, Q* is the optimal transfer quantity.

Conclusion: Consequently, the EOQ as a lot sizing tool is quite compatible with the principles of lean systems. The EOQ and other lot-sizing methods answer the important question: How much should we order? Another important question that needs an answer is: When should we place the order? An inventory control system responds to both questions. In selecting an inventory control system for a particular application, the nature of the demands imposed on the inventory items is crucial. An important distinction between types of inventory is whether an item is subject to dependent or independent demand. Retailers, such as JCPenney, and distributors must manage independent demand itemsthat is, items for which demand is influenced by market conditions and is not related to the inventory decisions for any other item held in stock. Independent demand inventory includes - Wholesale and retail merchandise - Service support inventory, such as stamps and mailing labels for post offices, office supplies for law firms, and laboratory supplies for research universities - Product and replacement-part distribution inventories - Maintenance, repair, and operating (MRO) suppliesthat is, items that do not become part of the final service or product, such as employee uniforms, fuel, paint, and machine repair parts Managing independent demand inventory can be tricky because demand is influenced by external factors. For example, the owner of a bookstore may not be sure how many copies of the latest best-seller novel customers will purchase during the coming month. As a result, the manager may decide to stock extra copies as a safeguard. Independent demand, such as the demand for various book titles, must be forecasted.